Market Update – July 2020
One of the sharpest falls in equity market history has been followed by one of the quickest recoveries. The US technology focused Nasdaq market is even up for the calendar year. This means the market thinks prospects for these companies are now better than they were six months ago. Meanwhile, in the real world, new Covid cases are accelerating again in the United States, unemployment is at depression era levels and the outlook for many businesses, including pretty much everyone in the entertainment and travel sectors, remains grim. How can this be?
It would be tempting to call markets irrational but we are not sure this is the case. IAG, the parent of British Airways, is down -65% from its market peak. Lloyds Bank is down over -50%. Meanwhile, the obvious winners from the crisis have done predictably well. Amazon and Netflix are both up over 50% since the crisis began. One of the impacts of the virus was to accelerate changes in society that were already slowly taking place. For some industries (like video conferencing, online delivery) we have accelerated into the future and the share prices of these companies reflect this. For the losers –oil and gas producers and physical retailers for example – the future looks to be one of, at best, steady, managed decline.
Putting all this together, global equity markets are down (only) -6% for the year as we type in US dollar terms. However, looking under the hood, the technology heavy US Nasdaq market is up +18% for the year. The UK FTSE All-Share Index – with its large energy and bank exposures – is down over -18%. You can criticise the markets for over-reacting to the current environment by assuming the changes we are seeing happen today carry on forever and under-valuing the probability that things return more or less back to normal once the pandemic has passed. However, we would be reluctant to call them irrational.
That said, based on client conversations we have had, the sharpness of the recovery in markets has surprised many of you. Here are the reasons we would offer to justify where we are today:
Chart 1: We are slowly getting better at dealing with the pandemic
1. Equity markets are not the economy. One key difference is that when we look at economic performance – GDP growth and unemployment rates for example – we are focusing on the economic conditions of today and the outlook for maybe the next 12 months. Equity markets, however, are forward looking. In theory the value of a company is the value today of all of its profits from now into the distant future. Say you took one year’s profits completely away from this calculation. The company’s valuation would fall but only by the value today of that year’s profits. Also, offsetting this is the fact that as interest rates fall (as they have) the present value of these profits today rises. So a -6% fall for the year (which is where we are today) does not look crazy on that simple valuation metric.
2. Equity markets are optimistic that the effects of the virus will slowly reduce over time. It is natural to take where we are today and to extrapolate that forward to think about future scenarios for the pandemic. However, this misses the fact that we are (slowly) getting better at dealing with this virus. This could be via better treatments for those with the disease or better test and tracing mechanisms to slow its spread. As an example of the former Chart 1 shows mortality rates for UK patients in hospital with the virus. These are down 2/3rds since the peak of the outbreak in March. It is hard to be sure when a workable vaccine will arrive. However, in the meantime it is reasonable to expect we will continue to adapt and get better at living with the virus. Equity markets in part reflect this optimism.
3. The reaction of governments and central banks has been unlike anything we have seen to any other crisis in history. We have written about this before but it is worth reinforcing just how different the response has been this time round. The US government (not normally known for its social welfare provision) has been mailing monthly $1,200 stimulus cheques to many of those affected economically. 1/3rd of UK private sector employees have been furloughed and are having salaries covered by the government. The total size of the German stimulus package is more than 50% of GDP (see Chart 2). This compares with the 2009 US stimulus package of around 5% of GDP that was focused on dealing with the 2008 financial crisis. And it is not just the size of the packages but also the speed with which they have been deployed. That US stimulus package only came into effect more than a year after the financial crisis had started.
Chart 2: Government support is huge
4. Central banks have also been buying bonds to pump money into the economy. In 2009 (again, a year late) these programmes only included government bonds. Today the US Fed, ECB and Bank of England are also buying corporate bonds in large volumes. This takes away one of the key risks of credit markets (who will buy this bond from me if I have to sell it in a crisis?). This has led to a sharp recovery in investment grade and high yield markets since central banks started their buying in mid-March. We wrote to clients around that time saying we would add to our corporate credit positions on the back of this central bank support. We did this in early April and have profited from some steady gains from our credit positions since then. As well as offering profits to investors, this has meant that credit markets have stayed open for corporate borrowers. In fact, Q1 saw the largest corporate bond issuance ever by US investment grade borrowers. This is all good news both for companies and their share prices.
5. Finally, these stimulus and support packages have led to a sharper economic rebound than markets were expecting at the end of Q1. As examples of this, US job growth (measured by non-farm payroll growth) rose by +2.5m in May confounding expectations of a -7.5m fall. German consumer spending also rebounded sharply in June (see Chart 3) benefiting from the largest support programme put in place by any government.
Chart 3: The initial recovery has been sharper than many expected in March
Of these factors, we think it is the government and central bank support packages that are the most important factors to explain where markets are today. If governments are prepared to step in and support the economy and central banks are prepared to step in and buy unloved bonds then tail risks are reduced. With governments and central banks taking the downside there has been only one direction for markets to go. However, the past is the past. Much of this good news is now priced in. What is the right strategy for the rest of the year?
Current Strategy and Activity
Before we look forward, it is worth revisiting what we wrote 3 months ago in our Q1 overview:
At times like these we are reminded of the work of Charlie Munger, the long-time business partner of Warren Buffet. His approach to risk management is simple (which came from guiding pilots in World War II): do everything you can to avoid the thing you really do not want to happen. If this sounds trite then we think we are really faced with two investment “risks” today:
- The market continues to go down and our equity and credit positions lose more money. Or:
- The economy heals, markets recover, and we are overly cautious and miss some of the rally by sitting in cash.
Which of these “risks” is the one to focus on avoiding? We come back to the time horizon point we started this discussion with. If your time horizon is a year or so then there is a good chance things get worse before they get better. Our focus would be on preserving wealth and cash looks a very attractive asset here.
However, as we discuss above, our time horizon for our clients is not 12 months but much longer. If you look at the history of financial markets (including all the wars, financial crashes, pandemics and recessions) it always pays to back human resilience and ingenuity in the long run. This too shall pass, our freedoms will return and economies will start to grow again. With this mind-set the risk to avoid is missing the recovery. This is therefore our focus.
It turns out we were probably too cautious about the next 12 months! However, our general philosophy remains the same. To predict where we are going next you would need to know what will happen next with the pandemic, how governments and central banks will react, how the economy will react to this support and finally how markets will react to all of the above. Just getting 2 out of 4 of these right would feel like an achievement. However, you would probably need to get all 4 right to make money by timing equity markets. This feels too complex a problem to risk your money on. We therefore remain focused on keeping within our risk limits for our portfolios and, with that constraint firmly in place, making sure we profit from the recovery as and when it comes. Broadly, this philosophy guided what we did in the first half of the year and helped us capture our fair share of the Q2 market gains as they came along.
This overall approach was also behind the three main areas of portfolio activity we had in the first half of the year:
- As equities fell, we bought on the way down – where appropriate. It turned out we were early and equities continued to fall. But after the central bank and government programmes were announced in mid-March the market rallied and we are now ahead on our purchases. We may yet have some more volatility ahead of us but we think these buys will prove to be entry points for longer term investments.
- Once central banks began to start buying credit we bought back the credit positions we had sold and added investment grade and high yield bonds. As we discuss above, with central bank buying reducing liquidity risks we think corporate credit is an attractive place to be and these positions also helped drive our Q2 returns.
- To fund our credit purchases we chose to sell most of our absolute return funds. The longer term returns from these assets have not met the targets we have for them and, because of their uncorrelated nature, there was no way of knowing how they would react in different market scenarios looking forward. Swapping the high likelihood of positive longer term returns from corporate credit for the more uncertain profile of absolute return looked like the right move to us.
Outlook for the rest of 2020
If you have made it this far through our note, one legitimate question might be: who is going to pay for all this money that is helping prop up the markets? The short answer is, of course, that we all will gradually over time. However, what might surprise you is that we think the obvious route to pay for all this (higher taxes) might not be needed much or at all.
To see why look at Germany with its 50% of GDP stimulus package. Say it borrows all of this from the markets (which today, include central banks of course). Today’s interest rate on German government bonds is minus 0.46% per annum. This means that for every €100.00 Germany borrows it pays no interest for 10 years and then has to pay back €95.40. The more it borrows the more money it makes! Crisis, what crisis!
The people who are really bearing the cost of all this borrowing are therefore the investors buying those bonds at a -0.46% per annum interest rate. This includes pension funds, insurance companies and other, more cautious, savers. The money they invest is, of course, our money so ultimately (some) savers will bear the cost of all this through (much) lower investment returns looking forward. One small piece of good news is that you are avoiding much of this cost by having your money with us rather than in a traditional pension fund! And though Germany is the most extreme example of this phenomenon (along with Japan) the same story is true across much of the developed world including the UK and the US.
So, if (as has been the case so far) central banks can print as much money as they want without generating inflation and governments can borrow more or less for free to provide support packages, what problems might this create down the line? The most obvious risk we see is that governments and central banks err on the side of doing too much rather than too little. We think the politics and economics are pushing them in that direction. The risk, then, is that we see a proper inflationary boom when all this ends and life returns to normal (or whatever normal looks like in 18 months’ time).
This thinking was also another reason for our move away from absolute return focused products. If a more inflationary world is coming our way we would rather own real assets with inflation protection built in. This category of investments includes (some) equities of course and property. It also includes the infrastructure and renewable energy assets we have added into client portfolios over the last few years. Given where bond yields are today, any asset which can deliver a reliable 5% or higher return with some inflation linkage deserves our attention. One advantage of the crisis is that some of these markets (especially listed property trusts) are trading at discounts to their net asset values so we have a decent entry point if we wish to buy. This will be an area of focus for us in the second half of the year and we hope to be able to add to our investments if and when we find attractive opportunities.
In summary then, our focus for the second half of the year remains as it was for the first. Keep our exposure to the market upside when and if it arrives (as, happily, it did in Q2), be ready to ride the volatility along the way and keep the focus on adding real assets to client portfolios when opportunities arise. If you want to discuss any of this in more detail then, as ever, please get in touch with us directly. Otherwise, we will continue to update you as and when we see significant market developments and we wish you all the best for the rest of 2020.